How ETFs work

There are more than 90 Exchange Traded Products listed in Australia, ranging from equities to physical gold and much in between.
AFR

by
Olga Galacho

Creating a diversified portfolio has been the top investment rule since an old-world sage coined the phrase “don’t put all your eggs in one basket’’.

But achieving the right mix of assets for a balanced investment is difficult and costly outside managed funds.

Or so it seemed until Exchange Traded Funds arrived on the ASX scene a few years ago.

Low-cost opportunity to spread risk

There may not be a broad awareness about exchange traded products yet, but investors who buy into them understand that they are a low-cost way of spreading risk without compromising liquidity or transparency.

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These types of investments combine the benefits of managed funds with the flexibility of equities, that can be bought and sold any time on a trading day.

There are more than 90 ETPs listed in Australia. They are invested across most asset classes, from equities to physical gold and much in between.

Many of them track local and offshore indices, allowing unitholders a slice of the action across any number of domestic or international shares with just one trade.

In Australia, ETFs trade on both a primary and secondary market. In the primary market, institutional investors can apply for and redeem large parcels of units in the fund, usually a minimum of $1 million, directly from the ETF issuer.

The units are then listed and traded in smaller parcels by market makers on the secondary market, the Australian Securities Exchange, allowing retail investors to buy them.

Regulations apply

Like any managed fund, an ETF must be registered with ASIC and be subject to Corporations Act regulations. Additionally, they must operate under a second regulatory framework known as the ASX AQUA rules, which specify investor protection requirements.

Unlike an initial public offering or a closed-ended listed investment company or trust with a predetermined balance, ETFs are open-ended schemes whose funds under management can keep growing.

The issuer is obliged to always offer applications and redemptions at net asset value on any trading day, making ETFs very liquid.

Traditionally, ETFs have been passive vehicles, simply tracking industry benchmarks such as the S&P/ASX 200 or the price of commodities.

UBS, however, has a new ETF that is more active and focuses on just 40 stocks, but all of which are highly regarded by the investment bank’s analysts.

How UBS picks its ETF portfolio

ETF capabilities manager at UBS,
Stephen Small
, explains that the group’s IQ Research Preferred Australian Share Fund selects ASX 200 stocks with a “buy" recommendation that are considered quality securities.

“Historically, one reason our type of product has not been available before is because research houses don’t want to disclose the intellectual property (behind their stock picks),’’ Mr Small said.

“The underlying UBS ETF portfolio first takes the ASX 200 stocks and narrows down the portfolio to those with a ‘buy’ recommendation on them.

“A further set of filters are applied that analyse the financial statements of those securities, looking at quality factors such as cash flow, debt levels and so on, therefore narrowing the portfolio down to the 40 best picks.’’

Mr Small said a weighting methodology is used to ensure the portfolio is more evenly allocated across the 40 stocks.

This removes some of the stock and sector concentration that occurs by holding too large an exposure to the benchmark’s top four or five stocks.

The result is a more even exposure across small, mid and large capitalised securities.

Rebalancing acts

Each month the portfolio is rebalanced to ensure that the stocks the fund tracks are those that continue to be highly rated by the investment bank research team.

“If you buy units in a fund that tracks the ASX-200, your exposure to small caps will be about 8 per cent of your investment. Whereas the UBS ETF has an approximate 30 per cent exposure to small caps,’’ Mr Small said.

“Retail investors may not have the expertise to select one stock over the other, hence this fund offers them the opportunity to gain access to all the leading UBS analyst stock selections in one transaction.

“When you purchase our ETFs, you have no counter-party exposure to the financial company you bought them off as the 40 underlying physical securities will be held on trust for the benefit of the end investor.’’

The ETF’s index of 40 stocks is created by UBS Investment Bank, which is an arms-length entity to the fund manager, UBS Global Asset Management.

How high is your financial IQ? In conjunction with UBS and BusinessDay, we are challenging you to answer our 15 IQ questions for your chance to win $10,000 worth of UBS IQ Research Preferred Australian Share Fund (ASX code: ETF) units. Simply click here to register today. Competition ends on 22nd February 2013.